Question

There are three factors that can affect the shape of the Treasury yield curve (r*t, IP_t, and MRP_t) and five factors that can affect the shape of the corporate yield curve (r*t, IP_t, MRPt, DRP_t, and LP_t). The yield curve reflects the aggregation of the impacts from these factors.

Suppose the real risk-free rate and inflation rate are expected to remain at their current levels throughout the foreseeable future. Consider all factors that affect the yield curve. Then identify which of the following shapes that the US Treasury yield curve can take. Check all that apply.

a) Downward-sloping yield curve
b) Upward-sloping yield curve
c) Inverted yield curve

Answer 1

The US Treasury yield curve can take on a downward-sloping, upward-sloping, or inverted shape, based on changes in the maturity risk premium, as both the real risk-free rate and inflation rate are expected to remain constant.

Step-by-step explanation:

The question is regarding the factors that can influence the shape of the US Treasury yield curve. There are three key factors: the real risk-free rate (r*t), the inflation premium (IP_t), and the maturity risk premium (MRP_t). Since the question states that the real risk-free rate and inflation rate are expected to remain constant, the only factor that may change the shape of the yield curve is the maturity risk premium.

Under these conditions, the Treasury yield curve could potentially be:

Downward-sloping yield curve: If shorter-term securities are seen as less risky, resulting in a higher demand and hence lower yields compared to longer-term securities.

Upward-sloping yield curve: This is the most common shape and occurs if investors demand a higher rate for longer maturities due to higher risk perceived over the longer term, which is typical when the economy is normal, and investors expect stability in rates and inflation.

Inverted yield curve: Although less common, this can happen if investors expect future interest rates to fall, often in anticipation of an economic downturn; in such cases, long-term yields may be lower than short-term yields.

Answer 2

b) Upward-sloping yield curve